What Are the Pros and Cons of Life Insurance Policy Loans?

You have to own a whole or universal life insurance policy if you want to borrow from your life insurance. Term life insurance policies do not have a cash value component, so they are not eligible for loans. However, if you own permanent life insurance (whole or universal) and you have built up a reserve of cash within it, you can usually borrow from it.

However, like any type of loan, life insurance policy loans come with pros and cons. It is important to look at both aspects before deciding whether to borrow against your whole life insurance policy.

Key Takeways

  • You cannot borrow from term life insurance policies.
  • You can only borrow from whole or universal life insurance policies when you have built up enough cash value.
  • Unlike other loans, borrowing from an insurance policy doesn't call for credit checks or payment plans.
  • You don't have to repay an insurance policy loan, but if you don't pay yourself back, you could face owing taxes or a lowered death benefit.
  • If you need quick access to cash, a life insurance policy loan is an easy way to access money.

Pros of a Life Insurance Policy Loan

Getting a life insurance policy loan is quick and easy. Since you are borrowing against your own assets, there is no approval process, credit check, or income verification. Policy loans generally have a much lower interest rate than bank loans and are devoid of high fees and closing costs. In most cases, they are also tax-free. After you request the loan, a check is usually received in five to 10 business days.

Funds from a policy loan can be used any way you choose. Because your policy's cash value acts as collateral for the loan, you can use the money for anything from household bills to a vacation. The insurance company does not require an explanation as to how you intend to use the funds. Unlike with a bank loan or credit card, there is no required monthly payment for a policy loan and no payback date. You can pay it off in two months or let it sit without making any payments for years. However, even if no payments are made, the loan accrues interest that is added to the balance of the loan.

Policy loans are not considered taxable income as long as the amount borrowed is equal to or less than the amount of premiums paid. Since the loan is borrowed against your own assets and does not hit your credit, the IRS does not recognize the loan as income; therefore, it is not taxed.

  • You can use the loan funds for whatever you choose.

  • Money from an insurance policy loan is not taxed as income.

  • It doesn't take very long to get access to your loan funds.

  • Loans do not have to be paid back.

  • The death benefit may decrease, if the loan grows too large and isn't repaid.

  • You will owe interest on the loan.

  • Failing to pay back your loan may result in taxation of the cash value borrowed.

Cons of a Life Insurance Policy Loan

If you were to die before paying back your policy loan, the loan balance plus interest accrued is taken out of the death benefit given to your beneficiaries. This could be a problem if your beneficiaries need the entire amount of the intended benefit. When the loan sits unpaid, the interest that accrues is added to the principal balance of the loan.

If the loan balance increases above the amount of the cash value, your policy could lapse and risk termination by the insurance company. In the event of a policy lapsing or being surrendered, the loan balance plus interest is considered taxable income by the IRS, and the taxes owed could be a fairly large amount depending on the initial loan and interest accrued.

Borrowing from your cash value may result in the collateral amount being moved from an investment account into a secure account. Any dividends earned on the investment account are decreased based on the amount of collateral secured.

What Does It Mean to Take out a Policy Loan?

A policy loan usually refers to a life insurance policy loan, which is done when you borrow from the cash value component in your permanent life insurance policy.

What Are the Consequences of a Policy Loan?

If you borrow from your life insurance policy and pay it back in a timely manner, the only consequence is you have less money earning interest on your policy during the loan. If you take out a policy loan and do not pay it back, you may owe taxes on the money you borrowed. Your death benefit could be reduced, or your life insurance carrier could cancel your policy⁠—putting you on the hook for paying back the loan with interest and paying taxes on the amount you borrowed.

Are Policy Loans Repayable?

Policy loans do not have to be repaid, but it is advised that borrowers replace the cash value they borrow, and keep up with their annual interest payments.

How Is a Policy Loan Made Possible?

Whole or universal life insurance offers a cash value component. The longer you have the loan, the more cash accumulates in the account. Usually, at the 10-year mark, you will have enough cash built up to borrow and the money is tax-free.

The Bottom Line

A big benefit of permanent life insurance is its cash value component, which you can legally borrow after it builds up. The funds are tax-free, and if you pay yourself back in a timely manner, it can be a beneficial way to use your policy.

There are not often timetables associated with these loans because payback on them is optional. However, you will have to pay the interest that is accused on the loan and if the loan and interest become larger than the cash value in your account, you may get hit with a tax bill and your death benefit may be reduced.

In addition, if you don't pay back the money you borrow, your cash value will shrink and if the money borrowed exceeds your cash value, you could owe taxes on the money you borrowed. Weighing the pros and cons of borrowing from a life insurance policy can allow you to make an informed decision about what can end up being a complicated loan.

Article Sources
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  1. Mass Mutual Insurance. "Taxes and Life Insurance -- FAQs."